Emphasize Stable Income
With rate volatility abnormally high, how can you construct a high income, stable return portfolio? And can the Fed begin cutting rates without harming the markets or the economy?
Balancing income and stability is the key to unlocking bond opportunities in 2024. After the rate moves in 2023, core bond yields are now more in line with their duration — the first time they’ve been this balanced since 2009. But this more balanced opportunity comes at a time when both realized and implied volatility levels are abnormally high, a risk regime that is likely to endure.
Over the next eight months, the Federal Reserve (Fed) will try to pull off a delicate passing of the baton in its policy relay race — transitioning from hiking to holding to cutting rates, without causing harm to the markets or the economy.
Amid high rates, increased volatility, mixed fundamentals, and evolving fiscal and monetary policy, bond investors should consider:
- Active core bond strategies, to pursue more yield with less volatility than indexed core bonds while navigating an evolving risk regime.
- Select short-duration bond exposures, where elevated yields offer income alongside the potential to minimize total risks — including reinvestment risk.
- Balanced high-quality intermediate investment-grade bonds, to take on more fairly compensated credit and rate risks, given their yield, duration, and spread profiles.
- Active high-income strategies, where allocating selectively across multiple credit sectors may help to diversify income and below investment-grade risks.
Historic Bond Losses and New Risks
The new balance for core bonds follows a painful record run of bond losses. The Bloomberg US Aggregate Bond Index (Agg) is down 15% over the past three years and roughly flat in 2023.1
Shorter term bonds have fared better, up 2% in 2023 with far fewer drawdowns over the past three years (max drawdown of -7% versus -17%).2 And they continue to screen as attractive. Given their low duration and the shape of the yield curve, they have historically had higher yields and more stability, as a result of lower total volatility, compared to core markets.
But short-term bonds have their own risks. Reinvestment risk, based on the selected tenor, may come more into focus if the Fed cuts rates — something that could reduce both the potential income and total return currently quoted by a segment’s yield to worst.
Credit offers strong income, but with uneven fundamentals. Rising default rates and tight credit spreads present challenges to total returns from potentially weaker price returns. Being selective among higher quality stacks of bonds may help to balance stability while seeking to earn the carry from the credit sector’s high coupons.
After Core Pain, Bonds Due for Gains
Over the past three years, core bonds have detracted from the standard 60/40 portfolio, given their significant negative returns since 2021. At the same, their diversification properties were also reduced, with the correlation of stocks and bonds increasing and turning positive as higher rates hurt both asset classes.3 Add in the weakest relative return trends in over 45 years — with US 1-3 month T-bills outperforming the Agg for a record 32 consecutive rolling 12-month periods4 — and it’s no wonder the rationale for including bonds in portfolios has been challenged.
But core bonds’ yield-per-unit-of-duration has moved from 0.65 at the start of the year to 0.90 — a level not seen since 2009 (Figure 1). And, for the first time since 2009, the Agg’s subsequent one-year total return could still be positive with even another 100 basis point (bps) rise in rates. This calculation is based only on duration effects, while holding other factors equal, using the commonly accepted formula (-Rate Change * Duration) + Yield + Rate Change.
More balanced breakeven ratios brightening bonds’ outlook is one reason bond allocations have increased heading into 2024. A recent Bank of America survey found that investors have turned the most bullish on bonds since the Global Financial Crisis — dumping cash in favor of holding the biggest overweight positions in bonds since 2009.5 ETF fund flows confirm the relative interest in bonds; bond ETFs have taken in 43% of all ETF flows, despite making up just a 20% of total ETF assets.6
But, credit risks challenge the notion of bonds being balanced to all risks. Also, higher yields coincide with higher levels of rate volatility. Realized volatility on the Agg is in the historical 96th percentile over the past 30 years.7 Meanwhile, implied rate volatility is in the 88th percentile over the same period.8
With volatility elevated, the ratio of yield-per-unit-of-volatility is not as balanced as the yield-per-unit-of-duration. Right now, the yield-per-unit-of-volatility is 34% below its long-term average (0.74 versus 1.13), as opposed to the yield-per-unit-of-duration trading right at its average.9
Still, the duration math suggests bonds are back — for income generation and total return, at least for the longer-term investor who can withstand some day-over-day volatility. And if the Fed does cut rates, there could be some duration-induced price appreciation for the first time in three years, ending a painful draught for bond investors.
Monetary Policy Shift and Reinvestment Risk
Consensus is for 50 bps of rate cuts by the July 2024 Fed meeting.10 But the March meeting likely will have the greatest impact on rate movements because the Fed will begin to foreshadow its shift in policy, consistent with how Chair Powell used forward guidance to prep the market for higher-for-longer rates during the Jackson Hole Symposium.11 March will also be exactly two years from when the Fed started hiking rates, consistent with research on the lag effects of rates.12
With Fed policy anticipated to moderate, forward looking estimates from consensus forecasts expect the curve to ever so slightly slope upward by Q3 2024.13 US 2-year forecasts are for 3.88% and US 10-year forecasts are for 3.90%, with steepening expected to continue toward the end of the year.
With lower rates, reinvestment risk becomes a risk factor — even more so if the Fed cuts rates as aggressively on the way down as it hiked on the way up. Given how sensitive ultra-short-term rates are to Fed policy rates, this could significantly impact investors who have flocked to cash-like, money-market mutual funds over the past year.
Roughly $1 trillion of assets have been deposited into those funds since the start of 2023, ballooning assets to over $5.7 trillion — a high water mark that coincides with significant inflows into ultra-short duration government bond ETFs.14 The roughly 5% yield those investors are earning today is likely to decline.
For investors staring down reinvestment risk, this just means that the once-considered-stable income of near zero duration government funds is likely to be a little more unstable in 2024. Adopting more of a total return mindset and moving further up the curve, even within short-duration tenors, may be a better option for investors.
Counter Rate Volatility with a Mix of High Quality and High Income Bonds
With bonds back in favor, but still subject to elevated rate volatility, a diverse mix of high quality and high income bonds can help investors stabilize their fixed income portfolios and limit volatility on the hunt for income and total returns.
With that in mind, consider the following:
Active Core Strategies
Go active in the core for income, total return, and volatility management. Today’s uncertain monetary policy path and mixed fundamentals call for active fixed income ETFs to help insulate your core bond portfolio from elevated volatility, while also pursuing income opportunities.
By combining traditional and non-traditional fixed income asset classes to maximize total return over a full market cycle, active sector allocation and security selection can help investors take advantage of income and total return opportunities, while also seeking to mitigate the credit and rate risks facing core markets.
Active managers’ ability to expand their opportunity set to include non-Agg sectors, or re-allocate capital along the yield and credit curve differently than how it is within the Agg, can be valuable heading into 2024.
For example, if an active manager held all of the same sectors of the Agg in 2023, but had one year less of duration, the manager would have outperformed the benchmark just from duration management.15 The same would be true if the duration matched the Agg but the manager held allocations to emerging market debt, high yield, or intermediate Treasury inflation-protected securities (TIPS) — three sectors with stronger returns than the Agg.16 In 2023, this ability to re-allocate capital has led to nearly 70% of intermediate core-plus managers beating their benchmark.17 Historically, the majority of active managers in this category have provided meaningful alpha (Figure 2).
Managers with a historical track record of generating above-benchmark yields with less volatility are well-suited for the core. And 2024 is likely to be a year where bonds, although they’ve never been more balanced in terms of duration risks, are still out of balance versus total portfolio risks.
Select Short-duration Bonds
Portions of the short end of the curve can offer elevated yields alongside the potential for more stable total returns than bonds further out on the curve.
The problem is reinvestment risk looms on the horizon. Particularly for all those assets invested in money market-like instruments. In 2024, to strike a balance among the objectives of income, stability, and reinvestment risk mitigation, investors should consider moving further out on the short end of the curve.
Focusing on short duration, not short maturity, is critical. And using duration as the screen allows for more securitized segments to be included in a portfolio that may have a long maturity — like mortgages — but far less duration given the structure of the securitization. Even just naively capping an Agg-based portfolio by maturity, and not by a duration of less than three years, leads to the removal of mortgages — a historically defensive sector with current attractive yields relative to Treasuries (5.5% versus 4.7%).18
Again, to construct a potentially high income, stable return profile, it’s a good time to consider active strategies that have the ability to blend different short-duration sectors. In 2023, this enabled 79% of active short-term bond managers to beat their benchmark.19
High-quality Intermediate Investment-grade Bonds
With broader core markets balanced versus rate risks, taking on some duration is not a bad idea. But it’s important to ensure that the duration risk assumed is being fairly compensated.
Consider tactically overweighting intermediate investment-grade corporate bonds with a maturity less than 10 years for these three reasons:
- Unlike high yield credit spreads, which are well below their historical averages (-22%),20 intermediate investment-grade corporate bonds are trading closer to their long-term average (-8%),21 so valuations are not as stretched.
- Owning bonds with maturities between 1 and 10 years, leading to a weighted duration of 4 years,22 allows investors to trim duration risk (and volatility) relative to the Agg, while also limiting reinvestment risk.
- Sitting in the short-plus belly portion of the curve allows a 1- to 10-year maturity exposure to strike a balance between yield, duration, and potential volatility from rate movements relative to other broader bond sectors (Figure 3).
Figure 3: Intermediate Investment-Grade Corporate Bonds Can Strike a Strong Balance Between Yield and Duration
By having some duration, if rates were to fall, the duration-induced price appreciation can add to the total return potential of an asset yielding over 5.75%. At the same time, given the yield/duration profile in Figure 3, if rates rise, a stable cushion can help offset duration-induced price declines.
Active High Income Strategies
All the negatives for below investment-grade bonds at the start of 2023 — tight spreads, more downgrades than upgrades, potential for rising defaults, and recessionary forecasts — remain as we turn to 2024.
The only difference is that high yield bonds, senior loans, and collateralized loan obligations (CLOs) produced some of the strongest returns out of any fixed income assets in 2023. Those three segments were up 7.8%, 9.6%, and 7.9%, respectively, while core Agg bond returns were flat.23 And those returns came with far less volatility than the Agg for both loans and CLOs.24
But fundamental risks are real. Defaults are forecast to rise to 3.5%, up from 3.0%.25 Meanwhile, downgrades are still outpacing upgrades — a trend that has now occurred for six straight quarters.26 Yet, the last two quarters have seen a moderation in pace. Nonetheless, the backdrop for credit is not incredibly attractive as spreads for high yield bonds are 22.0% below their average.27
But the carry, or coupon, from these high income sectors is too attractive to ignore. In fact, it was one of the major factors driving stronger total returns than the Agg in 2023, accounting for more than 70% of the total return of each of the three sectors mentioned above.28
Even with rates falling to close out 2023, high yield and CLOs offer yields over 7%, with loans over 10%.29 If markets stay resilient in 2024, the carry could counterbalance any credit risks like it did in 2023.
As a result, actively allocating across credit sectors like high yield, senior loans, and CLOs, as well as throughout the credit rating spectrum, can diversify income streams to help manage the risks in below investment-grade markets.
Implementation Ideas
To seek a balance between income and stability investment objectives in 2024, consider:
